Liquidity relates to the ease with which digital money, aka cryptocurrencies, is converted into other digital assets or fiat money. It’s crucial for a trader to purchase and sell crypto with no hassle and without meteoric market fluctuations, as this is the key to their success. Cash is, without a doubt, the most liquid asset since it can be rapidly gathered and spent on buying, selling, meeting immediate wishes and requirements, paying debts, etc. Consequently, cash is often adopted as a metric for deciding an asset’s liquidity.
As regards crypto exchanges, coins that can be converted into fiat money as quickly as possible are considered liquid. On the other hand, illiquid, i.e., non-liquid, purchases are usually sold privately because of dramatic price changes. With this in mind, you should pay attention to the liquidity of an exchange like Binance if you want to know the Ethereum price and not to find yourself in a situation where the transaction takes an eternity because of the illiquidity of that exchange.
Here are some fundamentals that we hope will shed some light on the concept of liquidity.
What makes liquidity such a necessity?
Liquidity has become a prerequisite for each tradeable asset, including digital currency. Hence, before indulging in trading, ensure you first understand the upsides of this concept:
Faster transaction times
When there is a great demand for a particular cryptocurrency, the exchange executes orders and trades rapidly. In the fast-paced virtual currency markets, it has become a requirement among participants to be able to initiate or leave a trade instantly. Tracking asset data, including the amount of trading, should be possible on a liquid exchange, so before purchasing, ensure you check on that.
Improved technical assessments
Technical analysis is considered an essential instrument for trading and market examination. That said, you should use it to research the technical indicators, previous prices, and chart patterns of the crypto that has caught your attention. This way, you can exploit false technical assessments and stay away from coins that have suffered dramatic changes throughout time
Factors influencing the liquidity of a crypto exchange
There are various factors impacting the liquidity of an exchange platform, some more expected than others. So, let’s see what it is all about.
Crypto exchange platform
An exchange platform allows users to purchase, sell, and exchange digital currencies. The platforms directly influence the number of trades in the market and hence liquidity. Nonetheless, the accessibility of virtual coins for users has increased dramatically over the years, which has also impacted the number of crypto exchange platforms. Today, there are more than 200 exchanges, among which only a few are P2P (Peer-to-Peer), and 21 are decentralized (there is no need for a third party to validate transactions). The rising number of exchanges gives users alternatives: they will choose the one that will offer them the best deals. For example, if pairs of desired assets are unavailable on one exchange, people will look for them on another. That being said, the exchange that manages to meet most market participants’ demands is more likely to lure users and hence thrive. When people trade massively on that platform, its liquidity will improve.
There is an unwritten rule in the crypto space: the more accepted a cryptocurrency is, the more useful and valuable it will become. A virtual currency must be widely accepted in order to have a fruitful existence. Since thousands of digital coins are out there and many more to be developed, it’s quite easy for one to vanish in favor of another. Bitcoin is the most adopted cryptocurrency at the moment, being accepted as a means of payment for various goods, including cars, jewelry, travel tickets, and insurance. The ultimate goal is that as many cryptocurrencies reach this level, indeed, but since this is a very unpredictable market, it’s hard to assume that each digital asset out there will be used as a payment method in the foreseeable future.
The volume of trading says a lot in terms of demand for a certain cryptocurrency. The number of coins bought or sold in exchanges in a day is referred to as volume. So, the more individuals move coins in exchanges, the higher the trading volume. This is perhaps the most influential factor when it comes to an asset’s value, and if you’ve just made up your mind to trade crypto, ensure you analyze the trading indicators seriously.
While countries such as El Salvador and the Central African Republic joyfully embraced Bitcoin as legal tender, others banned it. So, regulations and laws regarding the usage or trading of digital currencies differ from country to country, and it’s better to know about them before embarking on this journey. Since a ban or restriction on virtual currencies could mean fewer crypto exchanges or none at all, the liquidity is clearly affected. In this case, enthusiasts find it challenging to get their hands on cryptocurrencies and, more often than not, will choose other investment options.
Number of users
You might haven’t expected this, but the number of participants on a given exchange platform has a great influence on its liquidity level. This number, which manifests in both the number of users and their active wallets, shows that the exchange is a trusted one and can be used by other people looking for such services. The presence of a significant number of participants also proves that there is a strong community, which isn’t that common in such a competitive market. It’s somehow logical to assume that a low number of users will impact the strength of the exchange since there would not be many individuals trading out there – this directly manifests in selling at unfavorable prices.
That being said, if you’re about to take the route of cryptocurrency, ensure you’re aware of the factors influencing liquidity, as this can make or break the potential of your investment.